The FDR Framework is the backbone for a 21st century financial system. Under this framework, governments ensure that every market participant has access to all the useful, relevant information in an appropriate, timely manner. Market participants have an incentive to analyze this data because they are responsible for all gains and losses.

Wednesday, January 16, 2013

Bankers and Bonuses: gaming the system for personal advantage

The Guardian ran an excellent editorial in which it looked at the furor over bankers adjusting the timing of their bonuses so as to reduce the taxes they would pay.

The key takeaway is that it is the culture of the banks that bankers game the system for their personal advantage and that the only way to stop this behavior is through market discipline.

Please re-read the highlighted text as it nicely summarizes why your humble blogger has been advocating for requiring banks to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

It is only with ultra transparency, that sunlight can act as the best disinfectant and end a banking culture that supports bankers gaming the system for their personal advantages.

In the same way that sunlight resulted in the bankers ending their pursuit of minimizing their taxes by changing the timing of bonuses, it also would end the pursuit of misdeeds like manipulating benchmark interest rates like Libor.

Please re-read the highlighted text as it describes what bankers have been doing behind the veil of opacity that their 'black box' banks are shrouded in.

For those not following the story, let us recap. It emerged this week that Goldman Sachsplanned to defer paying its staff bonuses until after the start of the new tax year, in April.

That would enable its lavishly paid bankers to pay less on their hand-out since the top rate of income tax is due to fall from 50% to 45%.

That, let us not forget, is the rate George Osborne cut so as not to inconvenience Britain's highest earners. Since the average pay for a Goldmans staff member was confirmed on Wednesday as £250,000 (average, mind: the disbursements for investment bankers in the City would run far higher), workers would doubtless appreciate their employer's foresight.

Shareholders would lose nothing from the little wangle; it was merely the public purse that would be bilked of precious millions.

Naturally, the scheme is entirely legal: it saunters up to the limits of law, but goes no further. This is what bankers' gaming looks like.

Actually, in this instance, bankers' gaming was not illegal. But it is not always the case that bankers' gaming is legal. See manipulating Libor for an example of illegal bankers' gaming.

The best description of this state of affairs was provided by Mervyn King. "I find it depressing," he told the Treasury select committee, "that people who earn so much seem to think that it's even more exciting to adjust the timing of it to get the benefit of the lower tax rate … knowing this must have an impact on the rest of society, when even now it is the rest of society that is suffering most from the consequences of the financial crisis."

Please note some of the actors in the market place who can exert discipline on the banks when their activities are disclosed.

Up until that eleventh-hour U-turn, the entire situation smacked of the inevitable. It was inevitable that firms would look for a way to take advantage of the year-long notice the chancellor gave them of a change in top-rate tax....

The move, made in that omnishambolic spring budget, left the Treasury wide open to the tax-avoidance industry. It was inevitable that the pay consultants would dream up precisely such schemes and tout them round the City. And it was inevitable that, of all the banks, Goldmans – with its legendary contempt for public opinion – would think them a good idea.

What was not inevitable was that this week's spate of moral suasion would work. Not long ago the bankers might have brushed it aside as naive, and sheltered behind claims about immutable laws of the market.

Please re-read the highlighted text as moral suasion works when the market can see how the bankers are gaming the system.

Not discussed in the editorial was the simple fact that shareholders would have punished the banks' stock price if the bankers had gone ahead and adjusted the timing of their bonuses.

Why?

Because the moral outrage from the bankers' behavior would have then been directed at the new rules being drawn up to prevent another financial crisis. The moral outrage could have potentially resulted in far stricter rules and less profitable banks.

By backing down, the bankers hoped to avoid this outcome.

However, there is a clear lesson to be learned here: bankers respond to market discipline and as a result, the banks need to be made as transparent as possible.

About this blog

A blog on all things about Wall Street, global finance and any attempt to regulate it. In short, the future of banking and the global financial system.

This blog will be used to discuss and debate issues not just for specialists, but for anyone who cares about creating good policies in these areas.

At the heart of this blog is the FDR Framework which uses 21st century information technology to combine a philosophy of disclosure with the practice of caveat emptor (buyer beware).

Under the FDR Framework, governments are responsible for ensuring that all market participants have access to all the useful, relevant information in an appropriate, timely manner. Market participants have an incentive to use this data because under caveat emptor they are responsible for all gains and losses on their investments; in short, Trust but Verify.

This blog uses the FDR Framework to explain the cause of the financial crisis and to evaluate financial reforms like the ABS Data Warehouse.